Monday, October 15, 2007

Steps to Early Retirement

There is certainly no shortage of opinions on the steps to early retirement. In this post I’m going to outline the steps that I will be following and feel are necessary to successfully retire early.

Step 1Realizing that you Actually Need a Retirement Plan – this sounds simple but it’s amazing how many people don’t have a real retirement strategy. Many people save for retirement but have no idea how they are doing or how close they are to retirement. I’ve talked to people who’s “retirement strategy” is to work until 60 and then retire…but they have no idea of how much money they’ll need at 60, how much they’ll be receiving or how much they should be saving or investing. I think “Realizing that you Actually Need a Retirement Plan” is the most important but often overlooked step in many people's retirement journey.

Step 2Now that you know you need a real retirement plan you need to determine exactly how much money you’ll need each month and then add 10% to that number as a safety cushion. Probably the easiest way to do this is to keep track of your current monthly expenditures and then add and subtract any expenses/expenditures that you think you’d have in retirement ie- increased travel costs, decreased commuting cost etc...

Step 3Determine how you’re going to generate the required income you calculated in step 2. This isn’t an easy task and if you have no interest in investing or finance may require the help of a retirement planner or investment advisor. I’m not going to go over all of the available strategies as your retirement strategy should be tailored to your specific needs and risk tolerance. Personally, I am pursuing a dividend growth strategy, the rational for my decision can be found here.

Step 4ELIMINATE ALL DEBT – I personally believe that it’s crucial to ensure that when your retirement date arrives you have no debt of any kind (this certainly includes your mortgage). After you retire your employment income will be 0 so to protect yourself from unforeseen events (ie- rapid rise in interest rates) I am going to make sure that I am debt free when I retire. Some people will argue that it’s OK to retire with a small amount of manageable debt…but I disagree.

67 comments:

Anonymous
said...

Kudos to your retirement philosophy! The key to happy lifestyle and early retirement is not to be a slave to your money. It's very easy to spend more as you make more - but it's not easy working past 50. My take on life is to live below your means - as my income grows, expenses stay the same. The other thing is no other debt except mortgage - which absolutely must be paid off prior to retirement! Thanks for your blog! I enjoy reading it a lot.

I very much agree with 90% of your general retirement philosophy and also find that most people do not get through Step 1.

However, I'm not sure that all debt needs to be eliminated in all cases (although to be sure, in many cases it would be a good idea). If you have low interest fixed rate debt, unforeseen rises in rates will actually help you. For example, my mortgage is a fixed rate loan at 4.25%. Given that short term savings rates are above this number, I'm not exactly in a hurry to pay it off. Instead, I'm building up a contra-account to the level of the remaining mortgage balance. When I get ready to retire, the contra-account will be fully funded, and then we'll see where rates are. If they're at 4%, I'll pay it off. If they're at 8%, I can ladder risk free securities (e.g. CD's, treasuries) from the contra-account to pay off the mortgage.

A fixed rate mortgage with no prepayment penalty offers you an emormous benefit that some people can take advantage of -- if rates decline, you can always pay it off (or possibly even refinance it lower) -- if rates rise, you can always sit on it and pay it off with funds yielding more.

s.b., keep in mind that interest from your contra-account will be taxed at your marginal tax rate. Short-term savings accounts are not substantially better than your cuurent rate of 4.25% to offset the taxes you will pay on the savings. At this point, you are better off prepaying your mortgage.

Telly, that's true that the investment interest will be taxes at my marginal rate, but the mortgage interest is also tax deductible at the same marginal rate, so I think it's a wash. Having said that, I agree that 5.5% is not a huge differential over 4.25% right now.

s.b., good point - I didn't realize you were from the US. In Canada, our home mortgage interest is NOT tax deductible so to justify saving in a non-registered, income bearing account, someone in a 40% marginal tax bracket would have to earn >7% interest.

Telly, yes, you are of course exactly right if the interest is not deductible. (I can never keep track of which countries allow this and which do not. It seems there are more countries that do not than those that do.)

I realize I am really lucky to have a 4.25% mortgage. I just happened to get the mortgage back in 2003 right when rates were really low for a number of reasons. No smarts on my part -- just right place, right time. It is fixed and amortizes over 15 years. (Oh I wish it were 30 years!)

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